September 2006

GYC Investment Compass: Issue 2

Has the FED pause affected our previous view?

Dear Valued Client,

Since the last issue of GYC Investment Compass, the world has seen two more significant events. First, the US Federal Reserve (Fed) has decided to pause in its relentless hike of US interest rates in its August meeting. Secondly, war had tragically broken out in Lebanon, and threatened to drag in the world's superpowers into a proxy war against Iran and Syria. Thankfully, the situation has recently stabilised somewhat with a ceasefire in place, albeit a shaky one.

As an investor, we are sure you would be interested to know how these events could pan out, and how your investments can be sheltered, if not profit from these events.

Of the two major events, we think that the Fed's pausing of US interest rate hikes is more significant. The Fed was the first among the G7 economies to hike interest rates since the bursting of the internet bubble in 2001. It is significant to note that after 17 consecutive increases, they have chosen to pause by leaving US interest rates unchanged in the last FOMC meeting on 10 Aug 06. In examining the implications of this event, we are led to ask three questions:

  1. Has this affected our previous view?
  2. What are the implications for investors?
  3. What should I be doing to my portfolio?

Has this Affected Our Previous View ?

In our last letter, we outlined that the US economy was expected to slow down under the weight of tighter US monetary policy, higher oil prices, and a rapidly slumping US real estate market. In addition, we also expected inflation in the US to remain benign due to secular forces at work despite the rise in commodity prices, especially energy. These forces are globalisation, a global glut in labour, technology and competition.

As a result, it came as no surprise to us that the Fed has chosen to pause after a series of 17 consecutive point hikes in the Federal Fund rates.

Before the pause, investors' sentiments were hit by fear of stagflation caused by surging inflation and a sharp recession caused by tighter monetary policy in reaction to growing inflationary concerns.

Since the pause, a number of slowdown signals have lit up. The US housing market is weakening and a sharp slump may have already occurred. Auto sales are down and the farm sector is also weakening. Retail sales are no longer buoyant. US leading indicators are now pointing towards slower growth ahead. OECD leading indicators are pointing to a global slowdown. The UK and European central banks have tightened another notch during this period. China has not only introduced tightening measures on her economy, but also raised lending rates unexpectedly. Interestingly, financial assets have reacted positively to all these news.

Is a global recession imminent? We do not think so. In fact, we are now more convinced that we are entering into a mid-cycle slowdown - an investor friendly economic scenario.

Recession appears unlikely, with aggressive Central Banks being more vigilant and willing to take pre-emptive measures such as tightening interest rates on signs of inflationary pressures and then pausing or reducing rates should growth slacken and inflationary pressures ease, which is where the US is today. Also, as noted in our last letter, any localised excesses in the system are being dealt with by their respective local governments. For example, the runaway UK, Australian and US real estate markets have been separately tamed by the hikes in local interest rates.

This, of course, does not mean that accidents cannot happen. The mid-cycle slowdown scenario can be disrupted by a number of events :

  • An escalation of the war in Lebanon to include Iran and Syria
  • A worsening of the Iranian nuclear stand-off
  • A collapsing US dollar
  • An overheated global economy resulting in surging inflation
  • Over-tightening of interest rates by non-US central banks

As mentioned in the past, any one of these events could plunge the global economy into a sharp recession or stagflation nd fling capital markets into turmoil. But at present, we do not ascribe a large probability to these events unfolding.

What are the Implications to Investors ?

If the US is indeed going through a classic mid-cycle slowdown, investors will do well to start re-positioning their assets. In the 1985 and 1995 mid-cycle slowdown, both equities and bonds did very well, with equities coming up tops. In fact, equities gave investors hefty returns of about 50% over two years, since the beginning of the mid-cycle slowdown. Recent market actions have been very encouraging and it seems that history may yet repeat itself.

While we are bullish over both US bonds and equities, it may be different for the rest of the world. Some markets will do better or the same as the US, but some will obviously be found wanting due to a mixture of local and economic composition issues. Being in the right market at the right time is important and critical to successful investing.

We also advise against unrestrained optimism. It is clearly unwise to make reckless moves into financial assets. Prudence is key. Things can still go wrong. The key to successful investing is the ability to stay the course in the event the scenario does not pan out as expected.

What should I be doing in My Portfolio?

If you are holding mostly cash or very conservative instruments and have been waiting for the opportune moment to enter the financial markets, we think that this is the right time. Asset prices have corrected sharply from their recent highs. They have hit a low but have recovered somewhat. Even if you had not heeded our previous call to get in, it is still not too late to get in now. We are not saying that the market will not find new lows, but we think that there is a good probability that the market will be moving higher over the next two years. Call our advisers to help you make proper asset selections.

For those of you who have already invested but are holding back some excess funds for a better entry point, our message remains the same. Put these funds to work. In addition, you may want to review your current holdings to see if these are rightly positioned for the scenario we are expecting. A well-positioned portfolio is not only one that will benefit from current events, but also one that will not suffer immensely if the risk scenario becomes the central scenario. Call our advisers for a review.

For those of you who are currently committed to a disciplined investment program or a regular savings plan (RSP), we propose that you stick to this proven strategy of dollar-cost averaging. Do not increase your commitment beyond your ability to shoulder the additional risks involved. Call our advisers to discuss your portfolio re-positioning.

Look out for our next issue, where we continue to bring you more updates & analysis on the markets.

GYC Research and Investment Desk

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